China Begins Another Round Of SOE Reform

Earlier this year, Sinopec Group, China’s top oil refiner, announced the sale of a 29.99 percent interest in its retail sales arm to a group of twenty-five investors for RMB 105 billion ($17 billion). While the equity sale was a first of its kind transaction that raised a substantial amount of capital for one of China’s largest state-owned enterprises (SOEs), it was also an example of “mixed ownership,” one of the methods the government plans to employ in the country’s second round of SOE reform. The first round occurred in the late 1990s when the government spun off ownership of a large number of the smaller companies owned by the state to employees and private individuals. This time around, China wants to reform the country’s largest companies.

China has taken note of the fact that the country’s private companies are twice as profitable, more innovative and generate more new jobs than their SOE counterparts.Meanwhile, the monopoly positions held by many of the SOEs shut out smaller companies, limit competition and lead to low efficiency and poor services in many industries. To improve the performance of its large SOEs, China wants to move their cultures closer to those of the entrepreneurial companies in the country’s private sector.

Encouraging a mixed ownership model is one way the Chinese government plans to accomplish its objective.The impetus for this initiative originated in a Central Committee meeting in November 2013 where party leaders called for the rapid development of an ownership model that includes cross holdings of SOEs by state-owned capital, collective capital and private capital. Mixed ownership can come about through transactions like the Sinopec deal, but can also be accomplished through initial public offerings and other equity offerings on the Chinese and overseas stock exchanges. In addition to the 113 SOEs reporting directly to the Central Government, many of the large companies reporting to China’s provincial governments are being targeted as candidates.

Of course, implementation of the mixed ownership model begs the question as to whether the Communist Party and the Chinese government are prepared to take the ultimate step of true privatization where control of its most important companies is ceded to private investors. In fact, the concept of using “golden shares,” a type of preferred share held by the government that would allow the state to relinquish its majority shareholding in large national corporations, but give it veto power over key issues such as a revision of the articles of association or a takeover or acquisition by another company, is now under discussion.

While encouraging private ownership of its SOEs can be a step in the right direction, it’s only a half-step if the government is not willing to cede control, according to Marshall W. Meyer, a professor at the Wharton Business School. “To most observers, these will appear to be private companies, but they are state controlled entities — and when they are state controlled they might as well be state owned,” Professor Meyer said in a podcast on the subject. “It’s a waffle. It’s a compromise between outright privatization to which the conservatives in the party object very strongly and maintaining the present system, which isn’t working very well.”

Professor Meyer has a fair point. However, before China needs to address the very controversial issue of giving up control, there are several less contentious, interimsteps that China can take, in combination with mixed ownership, to reform its SOE’s. I discussed this and more in a recent interview with Philip Yin of CCTV America.

The first is a mechanism for creating effective boards of directors. Other than buying or selling their shares, investors do not influence managements directly, but do it indirectly through the individuals they choose to represent their interests on a company’s board of directors. Jack Welch, the legendary CEO of General Electric, once said that the best companies have the best boards. In addition to attracting private ownership, China needs to ensure that SOEs attract and appoint talented and accomplished individuals as directors.

Secondly, China needs to create an independent class of professional managers. Under the current system, individuals move between government jobs and executive positions in the country’s major companies in a single, intertwined career track. The CEO of a large SOE today may be the governor of a province tomorrow, creating a situation where the loyalties of key managers are divided between serving the interests of government and those of the company’s shareholders. While there will always be some movement between corporations and government based on individual aspirations, as there is in the United States, China needs to develop an independent career track for professional managers who want to focus on managing businesses and are evaluated solely on how well they have served the interests of shareholders.

Finally, SOEs need to develop executive compensation systems that incentivize SOE managers to serve the best interests of all shareholders. Needless to say, such an incentive system, where compensation will likely be higher for those running companies than for those who choose a career in government, cannot co-exist with the intertwined career track that now exists.

Better managed SOEs that are focused on creating shareholder value may well lead to layoffs and reduced employment at these companies, which is always problematic in China. That is why, in addition to reforming its SOEs, China must at the same time continue to reform its capital market, developing more ways to get capital into the hands of the small and medium enterprises that drive growth in any economy.

One Response to “China Begins Another Round Of SOE Reform”

Notion of China giving up control, especially in the “old industry”, is dream. Sinopec Retail was has no foreign investors (though they did bid). You never know, however, with Chinese government who is in a tight situation now with slow growth. A few months ago, they announced ecommerce can be 100% foreign owned. I believe this even shocked Hank Paulson, who has been a champion for China to allow higher foreign equity ownership %. Let us see after 5th Plenum.